Attachment J.5- West Bank and Gaza Inclusive Growth Diagnostic-May 2017.pdf

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May 2017

WEST BANK AND GAZA

INCLUSIVE GROWTH

DIAGNOSTIC

i

WEST BANK AND GAZA

INCLUSIVE GROWTH

DIAGNOSTIC

USAID Inclusive Growth Diagnostic Team – West Bank and Gaza

William Ayala

Tyler Holt

Matthew Hutcherson

Elias Khayyo

Terry Kramer

Paul Oliver

Lisa Ortiz

Adam Trowbridge ii

TABLE OF CONTENTS

EXECUTIVE SUMMARY ........................................................................................................... ix

ACKNOWLEDGEMENTS .......................................................................................................... xv

1 OVERVIEW & SYNDROME

1.1 OVERVIEW

1.1.1 Purpose and motivation

1.1.2 Methodology

1.1.3 Scope and limitations of the analysis

1.1.4 Challenges

1.2 SYNDROME: The Unrealized Political Settlement

1.2.1 From Syndrome to Constraint

2 THE WEST BANK AND GAZA GROWTH EXPERIENCE

2.1 West Bank and Gaza Economic Growth 1994-2016

2.2 Growth Decomposition

2.3 Private Investment

2.4 Capital Inflows

2.5 Trade

2.6 Labor Market Dynamics

2.7 Poverty and Inequality

2.8 Conclusion

3 FINANCE

3.1 Introduction

3.2 Examining the data

3.3 Conclusion

4 MICROECONOMIC RISKS AND DISTORTIONS

4.1 Global Performance on Microeconomic Indicators

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4.1.1 Business Environment Rankings & Indicators

4.1.2 Governance Indicators

4.2 Political Stability and Risk

4.3 Land Access and Land Tenure

4.3.1 Shadow Price Test for Land Access as a Binding Constraint

4.4 Transaction Costs

4.4.1 Trade and Customs

4.4.2 Test of Shadow Prices

4.4.3 Test of Camels and Hippos

4.4.4 Test of Camels and Hippos by Sector

4.4.5 Firm Structure

4.4.6 Test of Transaction Costs by Firm Size

4.5 Tax Rates and Administration

4.6 Business Regulatory Environment

4.6.1 Introduction

4.6.2 International Regulatory Rankings

4.6.3 Tests for Business Regulation as a Constraint

4.7 Corruption and Investment

4.7.1 Shadow Price Test for Corruption as a Binding Constraint

4.8 Conclusion

5 MACROECONOMIC RISKS AND DISTORTIONS

5.1 Introduction

5.2 Volatility of Economic Growth and Inflation

5.3 Consumption, Savings, and Investment

5.4 Public Finance

5.5 The Balance of Payments

5.6 Remittances

5.7 Conclusion

6 MARKET FAILURES

6.1 Introduction

6.2 Export Diversification

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6.3 Information Externalities

6.4 Conclusion

7 HUMAN CAPITAL

7.1 Summary

7.2 Public Sector Distortions of the Labor Market

7.3 Access to Education

7.4 Schooling, Enrollment, and Educational Attainment

7.5 Transition from basic education to secondary education, and trend of higher dropout rates among boys

7.6 Low Economic Returns to Education

7.6.1 Do domestic workers migrate or seek to leave, and how employable are they once they leave?

7.7 Distribution of Unemployment

7.8 Stakeholder Perceptions

7.9 Tests for Skills Mismatches

7.10 Health

8 INFRASTRUCTURE

8.1 Introduction

8.2 Sectors

8.2.1 Water

8.2.2 Energy

8.2.3 Transportation (roads, ports, crossing points)

8.2.4 ICT

8.3 Conclusion

9 NATURAL CAPITAL

9.1 Introduction

9.2 Land resources

9.3 Mineral & Natural Resource Wealth

9.4 Climate Change and Environmental Risk

9.5 Conclusion

References Cited v

LIST OF TABLES

Table 1.1 Principles of differential diagnosis

Table 1.2 IGD nodes, relevant sectors, and relevant implications

Table 1.3 Selected criteria for WBG comparators

Table 2.1 GDP Growth Rates in the West Bank and Gaza

Table 2.2 Patterns of poverty in West Bank and Gaza, 2003-2011

Table 2.3 Inequality Indicators: Gini Coefficient and Bottom 40% Income Share

Table 3.1 Banking sector characteristics

Table 3.2 Private Sector Credit and Real Interest Rates for Comparator Countries (2014)

Table 3.3 2013 Value of Collateral needed by Firm Size (% loan value)

Table 3.4 Use of financial services by firm size in West Bank and Gaza

Table 4.1 Doing Business Rankings (2017)

Table 4.2 Distribution of Land in the West Bank

Table 4.3 Doing Business Rankings for Registering Property

Table 4.4 Total Exports by Region (US$ millions)

Table 4.5 Select Enterprise Survey Trade Indicators

Table 4.6 Top Export and Import Partners (Goods)

Table 4.7 Transaction Cost Constraints by Firm Size

Table 4.8 Overall Doing Business Rankings

Table 6.1 Export Products by Country

Table 7.1 Educational Attainment by level among Palestinians (15 and older)

Table 7.2 Economic Sectors with Strong Potential for Job Growth

Table 7.3 Percent of firms identifying an inadequately educated workforce as a major constraint

(survey 2013)

Table 7.4 Percent of private sector firms offering formal training (2013)

Table 7.5 Beds per 1000 Population (2012/2013)

Table 8.1 Road Network Length in Kilometers in the West Bank by Road Type, 2015 vi

LIST OF FIGURES

Figure 0.1 Inclusive Growth Diagnostic framework (‘tree’) .......................................................... x

Figure 0.2 Summary of Diagnostic Tests in WBG ...................................................................... xiv

Figure 2.1 WBG Real GDP Per Capita, 1994-2015 (in 2004 prices, U.S. dollars)

Figure 2.2 Relative share of agriculture sector for income level

Figure 2.5 WBG Expenditure Components as percent of GDP

Figure 2.6 WBG and Comparators Gross Fixed Capital Formation as Percentage of GDP

Figure 2.7 WBG Gross Fixed Capital Formation and Components as Percentage of GDP

Figure 2.8 Gross Fixed Capital Formation and Components in West Bank (left) and Gaza (right) as percent of GDP

Figure 2.9 FDI, Net ODA, and Remittances for WBG (nominal values)

Figure 2.11 Labor Market Disaggregation

Figure 3.1 Real Interest Rate and Gross Fixed Capital Formation

Figure 3.2 Enterprises Financing Sources for Investment

Figure 3.3 Ease of Getting Credit

Figure 4.7 Largest Obstacle Faced by Firm (2006 & 2013)

Figure 4.8 Largest Obstacle Faced by Firms (West Bank & Gaza, 2013)

Figure 4.9 Largest Obstacle Faced by Firms (WBG & Comparator avg., 2013)

Figure 4.13 Percent of firms identifying political risk as a major constraint (by firm size)

Figure 4.14 Percent of firms identifying political risk as a major constraint (by exporter status, 2013)

Figure 4.16 Political Events and Economic Growth (constant 2004 US$), WBG

Figure 4.17 Map of Division of Land in the West Bank

Figure 4.19 Percent of Firms Identifying Customs and Trade Regulation as a Major Constraint 44

Figure 4.22 Days to Clear Imports and Exports from Customs

Figure 4.32 WBG Doing Business Rankings (outside is best; center is 190)

Figure 4.33 Regulatory Quality from World Governance Indicators

Figure 4.36 Trends in the Control of Corruption

Figure 4.37 To what extent do you think that corruption is a problem in the public sector in this country?

Figure 4.38 Over the past 2 years, how has the level of corruption in this country changed?

Figure 5.1 Growth and Inflation Volatility of Comparators, 2000-2015

Figure 5.4: Gross Savings and Adjusted Net Savings (% of GNI), 2014

Figure 5.5 Revenue by Type (nominal, USD millions)

Figure 5.6: PA 2016 Budgeted Expenditures

Figure 5.11: Compensation of Employees and Investment Income from Abroad vii

Figure 5.12: WBG Remittances in millions USD (nominal numbers)

Figure 5.13: Annual Growth Rates of Remittances and GDP

Figure 6.1 Product Space Mapping of WBG: 2005 (left) and 2014 (right)

Figure 6.2 Number of Export Commodities

Figure 6.5 Scientific and Technical Journal Articles Published per Million People

Figure 7.1 Desired Future Employment of Current Students (%)

Figure 7.4 Educational Attainment* vs. GDP per capita ($)

Figure 7.5 TIMSS Mathematics Scale (Overall, Grade 8 for 2011)

Figure 7.6 Rigidity of Employment Score (0, less restrictive to 100, most restrictive)

Figure 7.7 Wage Rate of Returns to an Additional Year of Schooling (includes wages of public sector employees)

Figure 7.8 Share of Employed West Bank Palestinians Working in Israel or its Settlements

Figure 7.9 Unemployment Rates by Years of Schooling

Figure 7.10 Employment Rates (% of each age group who are employed)

Figure 7.11 Labor Productivity, Avg. Growth, 2000-2014

Figure 7.12 Labor Mismatch: Unemployment Rates vs. Education

Figure 7.13 Cause of death, by communicable diseases and maternal, prenatal and nutrition conditions (% of total)

Figure 7.14 Under 5 Mortality Rate vs. GDP Per Capita

Figure 7.15 Health Expenditures vs. GDP Per Capita

Figure 8.1 Agricultural Irrigated Land (percentage of total agricultural land, 2013)

Figure 8.2 Incidents of Water Insufficiency in a Typical Month, 2013

Figure 8.3 Water Productivity, Total (Constant 2010 US$ GDP per cubic meter of total freshwater withdrawal), 2014

Figure 8.4 Access to Electricity (percentage of population, 2012)

Figure 8.5 Generator Use by West Bank and Gaza and Comparator Countries, 2013

Figure 8.6 Value Lost Due to Power Outages (percent of sales), 2013

Figure 8.7 Getting Electricity: Cost (percent of income per capita), 2016

Figure 8.8 Cost to Export (US$ per container), 2005-2014

Figure 8.9 Cost to Import (US$ per container), 2005-2015

Figure 8.10 Road Network in the West Bank

Figure 8.11 Roads Network in Gaza

Figure 8.12 Roads, Total Network (km per hundred sq. km), 2011

Figure 8.13 Quality of Port Infrastructure, Score (1-7, higher is better), 2015

Figure 8.14 Commercial Crossing Points Between the West Bank and Israel

Figure 8.19 Fixed Telephone Subscriptions per 100 People, 2015

Figure 8.20 ICT Service Exports (% of service exports, BoP), 2015

Figure 9.4 Building Stone Exports: 2005-2015

Figure 9.5 Water Stress Rankings: WBG & Comparators viii

LIST OF ABBREVIATIONS

AHLC Ad-Hoc Liaison Committee PA Palestinian Authority

DFID United Kingdom Department for

International Development PCBS Palestinian Central Bureau of Statistics

DISCO Distribution company PEC Palestinian Energy and Environmental

Research Center

DTF Distance-to-frontier PECS Palestinian Expenditure and Consumption

Survey (PCBS)

EADS USAID's Economic Analysis and Data

Services PENRA Palestinian Energy and Natural Resource

Authority

EBRD European Bank for Reconstruction and

Development PERC Palestinian Electricity Regulatory Council

EGY Egypt PETL Palestinian Electricity Transmission Company

EIB European Investment Bank PFI Palestinian Federation of Industries

FDI Foreign direct investment PLA Palestinian Land Authority

GDP Gross domestic product PMA Palestinian Monetary Authority

GIZ German Corporation for International

Cooperation PPA Power purchase agreement

GNI Gross national income PSA Power sales agreement

GOI Government of Israel R&D Research and development

HRV Hausmann, Rodrik, and Velasco ROW Rest of the world

ICT Information and Communication Technology STWS School to work surveys (ILO)

IEC Israel Electric Corporation SWTS School-to-Work Transition Studies

IGD Inclusive Growth Diagnostic SWTS School to work transition surveys (ILO)

ILO International Labor Organization TIMSS Trends in International Mathematics and

Science Study

ILS Israeli new shekel TUN Tunisia

IMF International Monetary Fund TUR Turkey

IPCC Intergovernmental Panel on Climate Change TVET Technical Vocational Education and Training

ISR Israel UNCTAD United Nations Conference on Trade and

Development

JDECO Jerusalem District Electricity Council UNESCO United Nations Educational, Scientific, and

Cultural Organization

JOR Jordan UNRWA United Nations Relief and Works Agency for

Palestine Refugees in the Near East

LBN Lebanon USAID United States Agency for International

Development

MAS Palestine Economic Policy Research Institute USD United States dollar

MCM Million cubic meter VAT Value-added tax

MENA Middle East and North Africa WB West Bank

MEPI Middle East Partnership Imitative WBG West Bank and Gaza

MOR Morocco WDI World Development Indicators

MSME Micro, small, and medium enterprises WGI World Governance Indicators

MW Megawatt WHO World Health Organization

NGO Non-governmental organization WRI The World Resources Institute

OCHA United Nations Office for the Coordination of Humanitarian Affairs WTO World Trade Organization

OECD Organization for Economic Cooperation and

Development ix

EXECUTIVE SUMMARY

Background

Since the signing of the Oslo Accord in 1993, the economy of the West Bank and Gaza (WBG) has struggled through more than two decades of war, conflict, and failed peacemaking attempts.

Throughout that time, the economy of the Palestinian territories, which continue to be heavily influenced by Israeli security controls and restrictions, has moved erratically from periods of rapid expansion and rising employment to periods of slow growth, rising joblessness, and high inflation, with average GDP growth since 1994 offset by an equivalent growth in population. As a consequence, Gaza is poorer today than it was in 1994.

For strong and consistent economic growth to occur in the West Bank and Gaza, private sector investment and entrepreneurship are critical. This process, however, requires an understanding of the constraints to economic growth. To facilitate this process, USAID and the Department of

State have conducted an inclusive growth diagnostic (IGD). The findings of that work are presented in this report.

Methodology

The foundational assumption of the IGD methodology is that private sector investment and entrepreneurship are critical for sustained and inclusive economic growth. Furthermore, to support that investment, the private sector needs (1) access to finance at a reasonable cost and (2) an expectation that they will receive a reasonable return on their investment, both of which are further unpacked and examined in the form of a diagnostic tree (Figure 0.1). Using this tree, the

IGD runs a series of data driven tests (see Chapter 1) to arrive at evidence-based conclusions regarding the bottlenecks to growth.

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Figure 0.1 Inclusive Growth Diagnostic framework (‘tree’)

Source: Hausmann, Rodrik, and Velasco 2005

Limitations of the Report

The IGD methodology focuses on utilizing existing data to examine where binding constraints to growth currently exist. As such, it is not intended to assess alternative possibilities that may exist in the future but do not exist today. Therefore, while the findings in this report point to valid and critical problems that currently exist in the Palestinian economy, in highly political and volatile situations, the conclusions of these findings should be reexamined if dramatic shifts in the

Israeli-Palestinian relationship were to take place (e.g. changes in access to Area C).

Furthermore, the IGD methodology does not prioritize results based on political feasibility or objectives other than economic growth and makes no recommendations on whether or to what extent other factors should be considered in formulating final programming decisions.

Findings

The analysis identifies both primary and secondary bottlenecks to growth hereto for referred to as binding constraints and secondary constraints/emerging issues. More specifically, a constraint represents a factor that is keeping the economy from growing. Although it can be tempting to think of all problems in the economy as binding constraints, the IGD methodology takes as its starting assumption that constraints are binding to varying degrees. In other words, while a number of issues may be relevant for economic growth, it is still possible to rank order these, in xi terms of “Which one, if relaxed will deliver the biggest bang for the effort.”

The purpose of the

IGD methodology, therefore, is to use rigorous analysis and a strict methodological framework to help identify constraints at the highest levels.

Binding Constraint

Microeconomic Risks

The analysis finds that microeconomic risks in the form of high transaction costs for doing business represent the most binding constraint to economic growth. In particular, the analysis finds that restrictions to movement, access, and trade represent the largest bottleneck to growth.

Movement and access issues include Israeli control of crossings in and out of the West Bank and

Gaza, the absence of airports and seaports, deficiencies in the import and export logistics chain, and numerous checkpoints within the West Bank.

This conclusion reflects the conclusion drawn by multiple recent analyses of the Palestinian economy, including reports issued by the World

Bank and the Peres Center for Peace.

At the individual firm level, the high cost of Israeli security restrictions and delays adds to transaction costs which reduce profitability of investments, limit access to customers and suppliers, increase the risk of business contracts, and prevent firms from pursuing more profitable activities. More specifically, in the context of the Palestinian economy, transaction costs include the high cost of shipping, long wait times at crossings, variability in administrative clearance times, burdensome and unique back-to-back shipping requirements, import restrictions via the dual-use list, and other many other costs associated with moving goods and people both within WBG and over the crossing points.

A related finding from this study is that the average firm in WBG is unusually small. Although the Middle East and North Africa (MENA) region are notable for atypically small firms, WBG nevertheless stands out with 87% of private sector firms in the small and medium category (from

5 to 99 employees), compared to 67% for the MENA region. This is particularly relevant since we also find evidence that smaller firms are less efficient at dealing with the high transaction costs that make up the binding constraint to the WBG economy. Moreover, while large firms create relatively more jobs (as opposed to small and medium sized firms) throughout the MENA region, only 1% of firms in WBG are large firms. Therefore, the small firm size has important implications for WBG’s ability to create jobs to absorb its growing labor force.

Doing Growth Diagnostics in Practice: A ‘Mind Book,’ Ricardo Hausmann, Bailey Klinger, Rodrigo Wagner, CID

Working Paper No. 177, September 2008.

At present, Israel fully controls access to, and the development of, 61% of the land in the West Bank (Area C) for both civil and security administration, and partially controls an additional 28% through joint security administration

(Area B). The Palestinian Authority fully controls only 11% of its territory in the West Bank (Area A), with civil administration and joint security control of another 28% (Area B).

xii

Secondary Constraints and Emerging Issues

Infrastructure

Although not the most binding constraint on the economy, the analysis shows that water and energy also pose important secondary constraints. In particular, limited access to water constrains growth in the productive sectors of manufacturing and agriculture. A lack of access to reliable water sources prevents water-intensive industries (notably agriculture) from expanding, leading most Palestinian agriculture to be primarily rain-fed. In other words, the report finds that water is scarce and expensive with a high incidence of insufficiency, thus reducing the profitability and increasing the volatility of many Palestinian businesses. More importantly, there is clear evidence that sectors with little reliance on water have grown more quickly than others which suggests that relying on water as a critical input to production makes it much harder for firms to succeed. In fact, anecdotal evidence suggests that some producers are attempting to bypass the lack of available water via high-cost purchases from tankers.

Like water, energy is also an important secondary constraint to economic growth, particularly in

Gaza where power outages are a persistent problem. Domestic production is extremely limited and electricity supplied from outside of WBG, especially in Gaza, is subject to cuts and limited hours of service, leading to people purchasing inefficient and costly generators.

While transport infrastructure is not, by itself, a binding constraint to growth, infrastructure deficiencies do contribute to the problem of high transaction costs to firms. Although improvements in isolated portions of the physical infrastructure network might be justified—to the extent that they help lower transaction costs for the private sector—the economic problems in transportation affecting private investment are much more a function of movement and access restrictions than the quality and adequacy of the physical infrastructure itself.

Macroeconomic Risks

Macroeconomic conditions also pose an important potential secondary constraint. Specifically, the fiscal deficit, although improving, could benefit from an expansion of the domestic tax base as well as a reduced burden on fiscal expenditures posed by the public sector wage bill. The

Palestinian Authority faces many long-term fiscal challenges including low tax revenues, declining budget support, and a high public sector wage bill. The largest source of revenue is clearance revenues, which are collected by the Israeli government and transferred to the PA accounts and expose the PA to additional fiscal risks should payments be delayed. However, there is evidence of improvement in domestic revenue collection and overall fiscal sustainability which suggests that macroeconomic risks may continue to decline over time.

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Conclusions

The analysis finds that high transaction costs to doing business, primarily associated with the movement of goods, access to commercial opportunities, and trade, are the most binding constraint to private sector investment and entrepreneurship in WBG. Limitations to movement and access include Israeli control of crossings in and out of WBG into Israel, the absence of airports and seaports, deficiencies in the import and export logistics chain, and numerous checkpoints within the West Bank. The analysis also finds that average firm size in WBG is unusually small. Since smaller firms are particularly disadvantaged when it comes to handling the high transaction costs of doing business, this finding is particularly noteworthy. Additionally, since larger firms create relatively more jobs than small and medium size firms, the absence of a significant numbers of larger firms means that the WBG economy will likely continue to struggle to create the necessary number of jobs to absorb its growing labor force.

Secondary constraints that the analysis has identified are access to water and energy and the macroeconomic environment, particularly as it pertains to the fiscal balance. Improvements in access to water and in the cost and reliability of energy (particularly for Gaza) can also be expected to improve WBG’s growth prospects as can a continued improvement in the fiscal balance. However, without the reduction of transaction costs associated with the mobility of goods and trade as outlined in more detail later in this report, improvements in secondary constraints will have a more limited impact on overall growth.

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Figure 0.2 Summary of Diagnostic Tests in WBG

TESTS

S h a d o w

P rice

Im p u lse-R ea ctio n

C ircu m v en tio n

C a m els &

H ip p o s IMPLICATIONS

BINDING

CONSTRAINT

Microeconomic

Risks

Prioritize reforms to reduce the transaction costs of doing business, particularly in the area of trade, and encourage firm growth.

SECONDARY

& EMERGING

CONSTRAINTS

Infrastructure

Prioritize water access, and for

Gaza in particular, energy. Focus on the development of improved infrastructure at crossing points and ports to facilitate smoother, faster trade.

Macroeconomic

Risks

Prioritize political solutions to improve the stability and predictability of economic growth and inflation. Closely monitor fiscal deficits.

NOT YET

BINDING

Market Failures

Finance

Human Capital

Natural Capital

Key

Test suggests constraint is significant.

Test suggests constraint is not significant.

Unable to conduct test.

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ACKNOWLEDGEMENTS

The members of the Inclusive Growth Diagnostic Team would like to thank the numerous people and institutions who provided their time and expertise to this project. We could not have completed this work without the generous contributions of colleagues in the West Bank and

Gaza and Washington, DC.

Special thanks are due to the many government officials of the Palestinian Authority and the staff members of think tanks, business chambers, and international organizations who took time from their schedules to meet with the IGD team during the in-country research phase of this project. We could not have completed this report without your generous assistance. We also want to thank those who provided assistance at USAID and the U.S. Consulate General in Jerusalem including Jarir Dirini, Fadi Abdellatif, Mark Hyland, Amal Tannous, Tony Rantissi, Peter Riley, Jim Turner, Samuel Rothenberg, Michael Bovin, and Mary Vargas. We also benefitted greatly from the many reviewers and editors in Washington including Nathan Martinez, Alexis Polovina, Caroline Smith, Laura Jagla, and Don Sillers. Georges Fadel from the USAID EADS team provided valuable support with data collection, research, and visualization.

The authors of this report take full responsibility for any and all errors and omissions. The views expressed in these pages are those of the authors and not necessarily those of the USAID, USAID West Bank and Gaza, the Department of State, the U.S. Consulate General Jerusalem, or the United States Government.

--- WA, TH, MH, EK, TK, PO, LO, AT

1 OVERVIEW & SYNDROME

1.1 OVERVIEW

1.1.1 Purpose and motivation

The purpose of the West Bank and Gaza Inclusive Growth Diagnostic is to diagnose the most binding constraints to economic growth. The goal of this report is to inform the programming and decision-making for the USAID West Bank and Gaza mission and the Consulate General in

Jerusalem.

1.1.2 Methodology

The growth diagnostic methodology was first described by Ricardo Hausmann, Dani Rodrik, and

Andres Velasco (HRV) in 2005.

Hausmann, Bailey Klinger, and Rodrigo Wagner wrote the

‘Mindbook’ operationalizing the HRV methodology in 2008.

“The foundational assumption of this methodology is that private sector investment and entrepreneurship are necessary for sustained economic growth. From this assumption, the methodology proposes two possible explanations for low levels of private investment and entrepreneurship: the expected private returns to investments are too low, or the cost of financing is too high. Under the first explanation, there is sufficient supply of financing for private sector investment to flourish but the demand for financing is too low because there are no profitable investments available to entrepreneurs. This can result from low social (economic) returns or low appropriability, which refers to the expectation that any profit from an investment will be ‘appropriated’ away for some reason. Under the second explanation, the cost of financing can be traced to either international financial markets or domestic financial markets.”

The authors of the methodology created an organizing framework, seen in Figure 0.1, to illustrate their argument. The chapters in this report broadly follow the divisions of this framework, or ‘tree.’

Hausmann, Ricardo; Rodrik, Dani and Velasco, Andrés. “Growth Diagnostics.” Harvard

University, 2005.

Hausmann, Ricardo; Klinger, Bailey and Wagner, Rodrigo. “Doing Growth Diagnostics in

Practice: A ‘Mindbook.’” Center for International Development, Harvard University, Working

Paper No. 177, 2008.

To operationalize the ‘tree,’ the authors offer four “principles of differential diagnosis” for identifying constraints to growth (Table 1.1).

Table 1.1 Principles of differential diagnosis

Principle Explanation Example

The shadow price of the constraint should be high.

The shadow price indicates whether the opportunity cost or value to a consumer is greater than the market price.

A price ceiling on gasoline creates a black market in which consumers pay a higher price.

Movements in the constraint should produce significant movements in the objective function.

When the constraint is relaxed, there is a positive market reaction (investment and entrepreneurship increase).

Referred to as the impulse-response test.

Reducing tax rates results in an increase in investment when tax rates are a constraint.

Agents in the economy should be attempting to overcome or bypass the constraint.

Economic actors should be taking observable steps to circumvent the constraint.

Referred to as the circumvention test.

Firms purchase generators instead of relying only on the grid when electricity is a constraint.

Agents less intensive in the constraint should be more likely to thrive, and vice versa.

Firms should flourish if they are better-suited to the domestic business environment. Referred to as the “camels and hippos” test.

Firms that are less dependent on infrastructure (e.g.

electricity) fare better when infrastructure is a constraint.

Source: Ricardo, Klinger, and Wagner 2008

No single principle or test is sufficient to declare a given constraint to be the most binding for economic growth. Instead, the methodology requires conducting multiple tests across each

‘node’ of the framework and aggregating these tests to make the most credible conclusion. Table

1.2 illustrates how the nodes are connected to specific sectors and conclusions.

Table 1.2 IGD Nodes, Relevant Sectors, and Relevant Implications

Node Sectors / Issues Negative Implications

Low Social Returns

Infrastructure

(Bad infrastructure)

Water, telecommunications, energy, roads, ports, etc. Poor inputs to production leading to low returns on investment Human Capital

(Low Human Capital)

Education, health system, labor market, etc.

Low Appropriability

Government Failures

Microeconomic Risks

(Enabling Environment)

Property rights, court system, regulation, corruption, firm-level tax policy, etc.

Inability to reap an adequate return on one’s investment

Macroeconomic Risks

(Enabling Environment)

Monetary policy, exchange rate policy, fiscal management, inflation, etc.

High uncertainty of potential return to investment

Market Failures

Coordination Failures

Market efficiency (e.g., availability of information on supply and demand)

Missed opportunities for maximizing profits

Information Externalities

Intellectual property rights legislation, patent laws, prevalence of R&D

Slow adaptation of technologies lowering profitable returns to investors

High Cost of Finance

Availability of Finance

(Low domestic savings and poor international finance)

Foreign Direct Investment

(FDI), financial institution access, financial market depth

Lack of access to finance

Cost of Finance

(Poor local Finance)

Financial market regulations, overhead costs, investment risk, collateral policies

Finance is available but too expensive to ensure a profitable return to investment

Source: Modified from South Sudan Growth Diagnostic Scoping Mission. USAID, 2013.

To apply the principles of differential diagnosis, we must benchmark the country of interest against other comparable countries, or “comparators.” Following USAID guidelines for conducting an IGD, our team employed a variety of criteria for selecting comparators, including the indicators in Table 1.3, as well as historical, political, and geographic considerations. Based on these criteria, we selected the following comparator countries: Israel, Jordan, Egypt, Lebanon, Turkey, Morocco, and Tunisia. Israel was included because of important historical and political ties and the inseparable economic relationship that exists today between the two countries.

Turkey is included as an “aspirational” comparator because of its higher GDP per capita and status as a middle-income country, and it provides some geographic diversity outside of the Arab world. At times, we also compare data to an aggregate of the Middle East and North African countries, if data is available, or averages of a unique set of MENA countries on a case-by-case basis as determined by the chapter author. Special comparator selections are described in sources or footnotes.

Table 1.3 Selected criteria for WBG comparators

Data are 5-year averages, 2011-2015

GDP per capita (2010

US$)

GDP per capita growth (annual %)

GDP per capita, PPP

(2011 US$)

Population growth (annual %)

Israel 32,409 1.6 31,286 1.9 Turkey 11,108 2.7 18,760 1.7 Lebanon 7,669 (4.3) 14,247 6.0 Tunisia 4,225 0.7 10,537 1.0 Jordan 3,981 (0.4) 10,252 3.1 Morocco 3,094 2.5 7,034 1.4 Egypt 2,667 0.3 10,097 2.2 West Bank and Gaza

2,554 2.8 4,546 3.0

MENA 3,999 (0.7) 11,596 1.8

World 9,917 1.5 14,128 1.2

Source: World Bank WDI

1.1.3 Scope and limitations of the analysis

While the IGD methodology can lead to significant and valuable insights that inform better decision-making, we want to make its limitations clear. Most importantly, this report will not prescribe specific interventions in response to our diagnosis of the most binding constraints to growth. In the same way that diagnosis and treatment of a disease are separate medical functions, we leave the ultimate ‘treatment’ of the binding constraints to others and hope that our analysis informs their decisions.

This limitation has three important implications. First, our analysis does not account formally for current reforms or initiatives that may impact economic growth. This stems from our reliance on data, which has not yet been collected on events still in motion. Second, our analysis does not attempt to incorporate the political economy of WBG into any prescriptions or recommendations. The priorities and policies of stakeholders in WBG and its neighbors may make it more or less likely that an intervention targeting the binding constraint to growth will succeed. Third, our analysis does not account for the cost-effectiveness of interventions. Beyond the potential political constraints to intervention, there may also be financial or economic constraints that limit the feasibility of action.

Further research, such as a political economy analysis of reform options for the WBG, or cost-benefit analysis at the project level, would provide a more comprehensive understanding of the types of interventions that would be both feasible and impactful.

1.1.4 Challenges

The Separation of the West Bank and Gaza

The West Bank and Gaza are most often grouped together as a single entity, and the authors of this IGD maintain that practice. However, as any close observer of Palestinian politics knows, today the West Bank and Gaza function essentially as separate territories both politically and economically. The Fatah-controlled West Bank is home to the official Palestinian Authority government while Hamas-controlled Gaza is largely autonomous, and restrictions of movement, access, and trade in Gaza are far more stringent than that of the West Bank. The authors of this

IGD are very aware of these issues, and although the West Bank and Gaza are grouped together as a single entity, we strive to identify to the extent practicable the uniqueness of each territory and the particular economic constraints of each. However, a close examination of each territory separately is not feasible in many cases due to data availability, and at times authors exclude the distinction if an issue is similar in both territories and separate discussions would become redundant.

Data availability

Data availability is generally very good for WBG, and the Palestinian Central Bureau of

Statistics, the Palestinian Monetary Authority, the Ministry of Finance, and other government institutions provide excellent public data sources in both Arabic and English. The most limiting factor is the lack of disaggregation between the West Bank and Gaza, particularly in World Bank data from the World Development Indicators. Some data sources provide disaggregation today but not in earlier iterations.

Benchmarking and time series

Our historic analysis usually begins in 1994 with Oslo Accords and the establishment of the

Palestinian Authority, and in most cases, data is available starting at least in the year 2000.

However, benchmarking and time series are challenged given the political separation of the West

Bank and Gaza in 2007 when bifurcation divided a country that was until that time far more politically and economically homogenous. For example, the World Bank Enterprise Survey did not disaggregate by region in the 2006 survey, yet by the time of the follow-up survey in 2013, the territories had undergone significant changes affecting private sector firms, particularly in areas of trade. The lack of disaggregation between surveys makes it impossible to do detailed analysis on disaggregated regional data.

1.2 SYNDROME: The Unrealized Political Settlement

The HRV growth diagnostic methodology recommends that the team identify a ‘syndrome’ that links the identified ‘symptoms,’ or constraints to growth. The failure of the Palestinian and

Israeli governments to reach a political settlement is the syndrome linking the economic constraints in the West Bank and Gaza.

Without a political settlement, WBG continues to operate as a partially-autonomous state without full legal recognition in many international organizations. After more than a century of war, peace negotiations, and agreements, WBG finds itself in a messy, unresolved status as neither a fully independent state nor a sub-national entity within another state. It does not control its own borders. Its people cannot easily move between the two territories or internationally. It cannot build its own seaports or airports. It does not have its own currency or monetary policy. It cannot collect its own customs revenues and must rely on revenue transfers from Israel. The list of economic constraints is long, and ultimately they originate from the syndrome that is the unresolved political settlement.

The syndrome is no surprise to experts who study Palestinian politics and economics, and the related issues of movement, access, and trade are referenced in almost any report on the

Palestinian economy. However, it is not obvious how those issues specifically impact private sector investment and entrepreneurship. In other words, it is not obvious how issues related to national politics and international relations impact firm-level decision making. The IGD methodology used in this report provides a rigorous methodological means to answer that question.

1.2.1 From Syndrome to Constraint

The syndrome manifests itself in the form of economic constraints in every branch of the IGD diagnostic tree. In finance, Palestinian banks are constrained by limitations on cash transfers from WBG to correspondent banks in Israel, and large amount of vault cash affect interest rates and lending practices. Social returns are low because Palestinians do not have full control of territory in the West Bank and cannot access many of the natural resources, namely water and offshore Gaza Marine gas fields, which they would otherwise use. Workers must pass through onerous checkpoints to reach better-paying jobs, and a skilled worker in Gaza who would like to work for a firm in the West Bank cannot do so without an Israeli permit. Palestinian firms must import and export goods through Israeli customs and security procedures. Shipments must undergo back-to-back transfer from Palestinian trucks to Israeli trucks to move across borders and crossing points.

These are just a few of the many examples of how the political syndrome impacts private sector investment and entrepreneurship. The challenge for the IGD methodology is to parse through these constraints and make a determination of which constraint is the most binding. The syndrome is not a constraint, but it ties together the constraints to tell a cohesive story of economic growth in WBG and the challenges faced in boosting growth rates. The remaining chapters of this IGD examine each node of the IGD diagnostic tree in detail to determine which constraint is most binding to economic growth in WBG, namely high transaction costs.

2 THE WEST BANK AND GAZA GROWTH EXPERIENCE

This chapter provides an overview of the recent economic experience of the West Bank and

Gaza (WBG) while providing context through comparator countries and aggregates. After an initial summary of trends in gross domestic product (GDP) growth, the chapter identifies the components and contributors to growth to the national economy including an overview of private investment, trade, labor market conditions, and poverty. Subsequent chapters examine the economic policies, institutions, and other forces that have shaped these outcomes.

2.1 West Bank and Gaza Economic Growth 1994-2016

Economic growth in WBG has been erratic in recent decades, with periods of major conflict negatively impacting economic growth. Other factors such as political and security instability, decreasing competitiveness, restriction of movement and access, and decreasing donor aid have also combined to dampen economic growth. As shown in the Figure 2.1, economic growth was strong between 1996 and 1999 due to a significant entry of public and private capital and the relative stability following the Oslo peace process and the founding of the Palestinian Authority

(PA) in 1994. However, the effects of the Second Intifada in 2000, with increased violence and political instability, put an abrupt end to growth, and the economy in both the West Bank and

Gaza severely contracted over the next three years. Growth resumed from 2003 to 2006 in response to renewed stability.

Figure 2.1 WBG Real GDP Per Capita, 1994-2015 (in 2004 prices, U.S. dollars)

Source: PCBS

1,000

1,500

2,000

2,500

Major Conflict WBG West Bank Gaza Strip

The growth patterns of the West Bank and Gaza changed significantly following major political and economic upheaval in 2006. At this time, internal divisions drove apart the Fatah-controlled

West Bank and Hamas-controlled Gaza, and a combination of international sanctions and the

Israeli closure policy on Gaza caused immediate and significant economic declines in Gaza.

Over the next three years, the West Bank continued its steady growth trajectory while the Gaza economy contracted to its lowest level in modern history. Meanwhile, in the West Bank, the steady economic growth that began in 2002 continued during a time when international donor support increased, the PA adopted economic policy reforms, and restrictions on movement eased.

However, from a peak of 12% GDP growth in 2011, the WBG economy dipped into a gradual decline starting in 2012 and culminated in an economic contraction in 2014. The Gaza economy was particularly impacted in this period by the Israeli destruction of illegal tunnels used for smuggling between Gaza and Egypt and by the war with Israel (Operation Protective Edge) in

2014. Donor budget support for the WBG had earlier contributed to public sector-led economic growth, but after 2009, official development assistance decreased, straining the PA budget.

Furthermore, movement restrictions imposed by Israel and a tight fiscal situation contributed to declining private and public sector investment, resulting in lowered competitiveness of the WBG economy. Moreover, most of the private sector investment that took place focused on residential construction rather than capital equipment and infrastructure in productive, tradable sectors such as agriculture and manufacturing.

While WBG GDP growth rebounded in 2015, it was at a relatively low rate of 3.4%, reflecting continued low levels of foreign investment and donor assistance, as well as Israeli policy impediments, such as the suspension of clearance revenue transfers to the PA early in 2015.

Nevertheless, Gaza’s economy grew at 6%, faster than the West Bank’s 2.6% growth, fueled by an up-tick in reconstruction activity following the 2014 war with Israel, as well as by the easing of some economic restrictions by Israel.

Overall, the frequent periods of political and military conflict between Israel and WBG have had serious and negative impacts on overall growth rates. There has also been a widening disparity in growth between the West Bank and Gaza, particularly after 2006 when the Israeli closure policy on Gaza began and trade was effectively eliminated. Since 1994, real GDP per capita in the West

Bank has increased by 52% while GDP per capita in Gaza has decreased by 26%. It is an alarming reality that Gaza is poorer today than it was 23 years ago.

IMF, pg. 14, “West Bank and Gaza” Selected Issues, September 11, 2013.

Table 2.1 GDP Growth Rates in the West Bank and Gaza

Average Real GDP Growth Rates

1995-99 2000-02 2003-05 2006-08 2009-15

West Bank & Gaza 3.80% -12.80% 8.50% -0.10% 2.80%

West Bank 5.60% -13.40% 6.30% 6.60% 3.10%

Gaza 0.50% -11.10% 12.90% -13.70% 2.30%

Source: PCBS

2.2 Growth Decomposition

Examining the breakdown of total GDP into sub-components through growth decomposition can be helpful to obtain information about the drivers of the economy and how it changes over time.

As shown in Figure 2.3 the Palestinian economy has followed service-oriented growth trajectory since the conclusion of the 1993 Oslo Accords. Services as a percentage of GDP has steadily grown from 60% in 1994 to 72% today with a concomitant decline in agriculture from 13% to

4.5%. The contribution of industry to overall GDP has declined slightly, but the manufacturing component of industry remains strong and has changed little over the past 20 years. Although these trends are typical for many developing countries, WBG’s high share of services (72%) and low share of agriculture (4.5%) makes it an outlier for a country of its level of economic development and is more typical of an upper-middle or even high income country. The data suggests that the Palestinian agriculture sector is underperforming and producing below expected output. As Figure 2.2 below shows, the agriculture sector represents a very small share of GDP given the WBG’s level of development.

Figure 2.2 Relative share of agriculture sector for income level

Source: WDI

An alternative growth decomposition provided by the Palestinian Central Bureau of Statistics shows the breakdown of GDP into private sector, government, and tax components. The most noteworthy trend is an overall decline in private sector contributions to GDP and the corresponding increase in government spending through public administration and defense. The rise in government contribution to GDP reflects increased public sector employment and a preference for many workers to find steady and high-wage government jobs. When disaggregated by region, as shown in Figure 2.4, the public sector in Gaza plays a significantly higher role in economic output compared to the West Bank, and the difference between regions really became stark after the 2006 Hamas takeover of Gaza and the restrictions to movement, access, and trade imposed on Gaza. Since then, private sector growth and productivity have declined significantly and left the government with a larger role in the economy as a percentage of GDP.

Source: WDI; PCBS

A second major trend in the growth pattern is an overwhelming economic reliance on consumption. Figure 2.5 displays the expenditure components of Palestinian GDP from 1994 to

2015. The share of private household consumption makes up a significant portion of GDP with an average of 92% for this period, though it has declined to 86.9% as of 2015. Government spending is the second highest contributor to GDP growth, which is not surprising given the increase in contribution by public administration and defense to GDP growth since 1994.

Meanwhile, gross capital formation (a proxy for investment) went from 33.8% of GDP in 1994 to 21.7% in 2015. The large trade deficit (-40.7% in 2015) makes this aspect of the WBG’s economy unique given that it is far bigger than any comparator country, and the majority of its trade is with one country (Israel). The trade imbalance has improved steadily as a result of a rise

199719992001200320052007200920112013

Agriculture Industry Services

Figure 2.3 West Bank and Gaza, Value-

Added by Sector, World Bank (% of GDP)

Gaza West Bank

Figure 2.4 Value-Added by Public

Administration and Defense (% of GDP) in exports from 13.3% of GDP in 1994 to 21.5% in 2015. The microeconomic chapter elaborates further on the trade dynamics.

Figure 2.5 WBG Expenditure Components as percent of GDP

2.3 Private Investment

Private investment is an important contributor to economic growth, and an examination of investment levels and trends is important to better understand the contributions and challenges to private sector led growth. Unfortunately there is limited data on private capital formation in the

WBG, but looking at the broadest levels of investment (gross fixed capital formation), WBG ranks near the median of the comparator countries, as shown in Figure 2.6. In fact, total investment levels ranked third in 2015 among comparators at 23.7% of GDP.

-100

-50

Gross Capital Formation Non-Profit Institutions serving households (NPISH)

Government Consumption Household Consumption

Net Exports of Goods and Services

Figure 2.6 WBG and Comparators Gross Fixed Capital Formation as Percentage of GDP

Disaggregating this data for the WB and Gaza, it is evident that investment in real estate and related construction makes up the bulk of gross capital formation, as evident in Figure 2.7. The likely explanation for this is that given the economic uncertainty due to political, security, and economic instability, investment in real estate is seen as most secure. Unfortunately for the growth of other parts of the economy, non-real estate investment has not risen to more than 11% of Palestinian GDP.

Figure 2.7 WBG Gross Fixed Capital Formation and Components as Percentage of GDP

Source: Palestinian Central Bureau of Statistics (PCBS)

1994 1995 1996 1997 1998 1999 2000 2001 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

West Bank and Gaza Egypt Israel Jordan Lebanon Morocco

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

Gross Fixed Capital Formation a) Buildings b) Non-buildings

For the West Bank, investment in buildings has been steadily increasing since 2006, whereas all other investment has remained flat at less than 8% of GDP (Figure 2.8a). For Gaza, real estate investment has been the bulk of gross capital formation and, due to the collapse on other investment, the only significant investment since 2007 (Figure 2.8b)

Figure 2.8 Gross Fixed Capital Formation and Components in West Bank (left) and Gaza

(right) as percent of GDP

2.4 Capital Inflows

The West Bank and Gaza has received most of its capital inflows from official development assistance and remittances, as evident from Figure 2.9. Capital inflows from foreign direct investment (FDI) have been very low and are in fact the lowest among all comparator countries.

Official development…